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Understanding Amortization

When you’re applying for a mortgage, there is sometimes confusion with respect to the amortization. Putting it simply, the amortization is the number of years it will take you pay off your mortgage. This is not to be confused with the term of the mortgage. As with most things, there are both advantages and disadvantage to the length of the amortization – A longer amortization will keep the payments lower, and with this more affordable. A shorter amortization will pay the loan off quicker and could save tens of thousands of dollars in interest.

Based on current rates of around 3% and a $400K mortgage, a 25 year amortization would cost about $1892 per month and total interest over the 25 years of about $168K. The same mortgage based on 20 years would cost about $2215 per month & $132K in interest. The 20 year AM would save about 36-thousand dollars in interest over the life of the mortgage.

Over the past few years, there have been some significant changes brought about by regulators with respect to maximum amortization periods. Currently, the maximum amortization for any insured mortgage (less than 20% down) is 25 years. In 2012, that was brought down from 30 year, and 35 a year earlier. If we go back a few years prior to this, we had 40 year amortizations.

Keeping the same numbers ($400K mortgage & 3% rate), with a 25-year amortization, would need about $80K of household income to afford this mortgage. For same mortgage with a 30-year amortization would require only about $72K of household income.

If you have the 20% down payment, there are still options to get a 30 year amortization.

The question next becomes, does a longer or shorter amortization period make more sense for you. Before answering this, you need to fist look at both your budget and your goals. Another consideration is what will happen when the mortgage comes due for renewal (from the current term), as rates may be significantly higher than the current low rates.

I’ll run through an example with the chart below:

Initial Mortgage

Initial Rate

Initial Amortization

Payment

Balance at 5 years

Remaining Amortizaion

Renewal Rate

New Payment

$400,000

3%

25 years

$1,893

$341,897

20 years

5%

$2,247

$400,000

3%

20 years

$2,215

$321,091

15 years

5%

$2,531

Looking at this chart, if they were comfortable with a payment of about $2,200 per month, then taking the 20-year amortization may make sense. In 5 years however, if you started with the 20-year amortization and rates are back in the 5% range, your payments would increase to a little over $2,500 per month, which may make your mortgage a little too expensive. Taking the 25 year amortization today however, would keep your payments within your comfort level in 5 years.

Of course, it’s difficult to predict where rates will be in 5 years. My advice in most circumstances is to take the longest amortization possible, and select a mortgage with good pre-payment options. This keeps your required payment lower, with the option to pay more. Any additional payment will go entirely toward principle which will reduce the overall amortization & borrowing costs. This gives a few more options to keep payments within your comfort range should rates rise in the future, and also gives more flexibility should circumstance change (such as illness or job loss) and you’re not able to maintain the higher payment.

When your applying for a mortgage, speak with your mortgage broker to make sure you’re getting the mortgage that best suits your needs.